**Abstract**

This study aims to analyze the risks on Islamic banks in Indonesia by identifying which risk is significantly dominant in triggering other risks to happen. For that purpose, the study uses time series data on a monthly basis from 2010:M1 to 2018: M8. The data are obtained from the Financial Services Authority (OJK) Indonesia and analyzed using vector autoregression (VAR). Some variables are employed to proxy risk vulnerability including financing-to-deposit ratio (FDR) as a proxy of liquidity risk, nonperforming financing (NPF) as a proxy of financing risk, and cost-to-income ratio (BOPO) as a proxy of operational risk. The findings suggest that financing risk is the most dominant risk triggering vulnerability on Islamic banks in Indonesia.

**Keywords:** liquidity risk, financing risk, operational risk, Islamic banks, Indonesia

### **1. Introduction**

In 1997, the financial crisis began in Thailand and had destroyed economies of Asian countries, especially countries that had similar economic typologies. This crisis was triggered by speculators who launched a barrage of "attacks" on the Thai currency. Its currency became more deteriorated as the economic structure of Thai currency was not accompanied by strengthening in the real sector [1].

Given such important aspect on exchange rate stability, Bello et al. [2] argue that the efficiency of risk management practices on currency volatility can be sought as the main reason for a banking collapse. The banking collapse is mainly due to mismatch problem in its balance sheet. The balance sheet becomes imbalance as the growth of its assets linked to foreign currency is not as equal as the growth of its liabilities linked to foreign currency. Consequently, risks such as liquidity risk, credit risk, and operational risk are appeared. These risks will impair gradually the bank's balance sheet; hence, this condition would need a special treatment and force a bank into a critical level until it receives bailout funds. Subsequently, when the risks were not mitigated properly, it might transmit into financial system and economic at large.

One example of the impact on banking failure into financial crisis was in August 2007. A financial crisis started when one of the largest French banks announced a freeze of some securities in the United States concerning high-risk housing loans (subprime mortgage). This incident triggered a decline in the level of public confidence in the banking sector and led to bank failures around the world.

Liquidity crisis causes declining in the household and corporate sectors' confidence toward economic conditions. The long-term pressure on banking sector had flowed to currency depreciation, strong inflationary pressures, and rising interest rates [3]. unutilized funds, which will burden the bank's balance sheet as profit diminishes, while the greater proportion on the left-hand side implies excessive utilized funds than deposited funds. Therefore, the imbalance, which potentially occurs as continuous banking operation, will always create risks, in the form of financing risk,

Although Islamic banking cannot avoid from risk promulgation, there is no adequate evidence on what the source of risk which can lead to balance sheet's vulnerability. The existing literature however mainly focuses on factors that lead to build-up risk in Islamic banking. For example, studies by Abdullah [6], Abedifar et al. [7], Adrian and Hyun (2013), Alessi and Detken [8], and Ardiansyah et al. [9] specifically merely elaborate the determinants of risks and their relationship with a particular risk, such as credit, liquidity, and operational risks. In addition, other studies by Avdjiev et al. [10], Aysan et al. [11], and Borio [12] focus on the

relationship of bank's risks with its stakeholders without taking peculiar attention to which risks frequently arise. Therefore, this study will close the gap by empirically examining what is the dominant risk in the Islamic banking given the dynamic and interrelated sides—funding and financing sides—on its operation. For that purpose, three main risks are observed—credit, liquidity, and operational—given that those risks are financially connected to Islamic banking operation. Finally, this paper contributes to the literature on risk management by investigating empirically what is the dominant risks, which are quite lacking, particularly looking at Indonesia's case. Hopefully, findings of the paper share benefits to bankers, depositors, investors, and

Risk arises when there is an unknown or unclear outcome and usually disrupts a particular system. According to Misman [13], risk is the volatility of unexpected results or variability. Risk can be divided into two types, systematic risk and unsystematic risk where numerically it can be measured by standard deviation of historical results. The main risks in the banking system, including Islamic banking, are credit and liquidity risks. The credit cycle, a mismatch of balance sheets [12], and funding constraints [14] are some of the triggering factors for risk exposures. These factors could deteriorate the banking system as a result of an inability to diversify their portfolios [15] and loan syndication [16]. Therefore, to manage risks in the banking system, credit risk and liquidity risk should be linked with the rate of growth of a bank's aggregate balance sheets that remain surplus (high liquidity

According to Wiranatakusuma and Duasa [21], there are two important risks that are embedded in Islamic bank, which include liquidity risk and credit risk. Credit risk issues are related to banking operations amidst high-nonperforming loans. Banks as financial intermediaries have to meet short-term obligations. When a bank fails to settle its obligations, that means the bank is at risk of bankruptcy. When there is long failure of insolvency situation, the capital will be affected due to the emergency need in maintaining operations and the systematic risk mitigation. Therefore, credit risk is followed by operational risk as capital is gradually eroded. Subsequently, insolvency in financing disbursement would affect the left-hand side (bank-depositor relationship) as the bank is unable to settle its deposited funds' return. It was the signal that the bank is facing liquidity problem due to balance

Therefore, to further clarify the credit, liquidity, and operational risks, some

regulators when taking decisions related to the Islamic banking industry.

liquidity risk, or operational risk.

*Risk Analyses on Islamic Banks in Indonesia DOI: http://dx.doi.org/10.5772/intechopen.92245*

**2. Literature review**

sheet's mismatch.

**53**

studies explain as follows:

borrowers and short-term debt) [17–20].

Looking at the severe impact of banking failure, it can be traced out from to what extent the risk is systematically related among systems. According to Bank Indonesia [4], the systemic risk is the main reason on severe impact from the banking failure as it causes instability as a result of contagion in some or all financial systems. The systemic risk happens due to dynamic interaction components within a financial system referring to theirs size, complexity, interconnectedness of institutions and financial markets, and excessive behavioral tendencies from actors or financial institutions to follow the economic cycle (*procyclicality*).

Given such dynamic circumstances, it can trigger banking sector vulnerability and jeopardize economic growth through uncontrolled banking risks. Some common and influential risks in banking sector include the following: *First*, liquidity risk refers to banks that cannot meet the needs of customers due to mismatch balance sheets. According to the Banker Association for Risk Management, liquidity risk is influenced by several factors, including accuracy of cash flow planning, accuracy in managing funds, availability of assets that are ready to be converted into cash, and the ability to create access to the interbank market. Financing-to-deposit ratio (FDR) is used to proxy the liquidity risk given that it represents the potential of liquidity shortage.

*Second*, credit risk is the risk of loss due to the failure of the counterparties to fulfill their obligations. Credit risk arises from a variety of functional bank activities, such as credit (financing in Islamic banks), treasury activities (placement of funds between banks, buying corporate bonds), and activities related to investment and trade financings. Nonperforming financing (NPF) is used as a proxy to measure credit risk due to greater NPF, which indicates bank vulnerability as it can erode bank's capital through a gradual decrease in profitability.

*Third*, operational risk is the risk caused by inadequate or non-functioning internal processes, due to human error or technological system failure and external events that affect the bank's operational performance. According to Aldasoro et al. operational risk represents a significant portion of the total bank risks in the banking sector. In this regard, it needs to be measured by considering operational losses compared to operational income, which is proxied by a cost-to-income ratio (BOPO) variable.

The potential risk arising in the banking sector is based on basic banking operational framework. In the case of Islamic bank, **Figure 1** shows the sequential processes which embed risks in every step involved. Bank as a financial intermediary has the main function in connecting left-hand side (funding side) and right-hand side (financing side). The connection implies a build-up risk given that a balance sheet mismatch occurs. Referring to **Figure 1**, number 1 is connected to numbers 2, 3, and 4, which indicates funds deposited are subsequently utilized for financing purposes. Mismatches can be due to dominant proportion between right-hand and left-hand sides. The higher proportion on the left-hand side implies excessive

**Figure 1.**

*Islamic banking as a financial intermediary. Sources: Bank Indonesia [5]. 1. Money deposited; 2. Money withdrawal; 3. Financing contract; 4. Profit loss sharing.*

#### *Risk Analyses on Islamic Banks in Indonesia DOI: http://dx.doi.org/10.5772/intechopen.92245*

Liquidity crisis causes declining in the household and corporate sectors' confidence toward economic conditions. The long-term pressure on banking sector had flowed to currency depreciation, strong inflationary pressures, and rising interest rates [3]. Looking at the severe impact of banking failure, it can be traced out from to what extent the risk is systematically related among systems. According to Bank Indonesia [4], the systemic risk is the main reason on severe impact from the banking failure as it causes instability as a result of contagion in some or all financial systems. The systemic risk happens due to dynamic interaction components within a financial system referring to theirs size, complexity, interconnectedness of institutions and financial markets, and excessive behavioral tendencies from actors or

Given such dynamic circumstances, it can trigger banking sector vulnerability and jeopardize economic growth through uncontrolled banking risks. Some common and influential risks in banking sector include the following: *First*, liquidity risk refers to banks that cannot meet the needs of customers due to mismatch balance sheets. According to the Banker Association for Risk Management, liquidity risk is influenced by several factors, including accuracy of cash flow planning, accuracy in managing funds, availability of assets that are ready to be converted into cash, and the ability to create access to the interbank market. Financing-to-deposit ratio (FDR) is used to proxy the liquidity risk given that it represents the potential of liquidity shortage. *Second*, credit risk is the risk of loss due to the failure of the counterparties to fulfill their obligations. Credit risk arises from a variety of functional bank activities, such as credit (financing in Islamic banks), treasury activities (placement of funds between banks, buying corporate bonds), and activities related to investment and trade financings. Nonperforming financing (NPF) is used as a proxy to measure credit risk due to greater NPF, which indicates bank vulnerability as it can erode

*Third*, operational risk is the risk caused by inadequate or non-functioning internal processes, due to human error or technological system failure and external events that affect the bank's operational performance. According to Aldasoro et al. operational risk represents a significant portion of the total bank risks in the banking sector. In this regard, it needs to be measured by considering

The potential risk arising in the banking sector is based on basic banking operational framework. In the case of Islamic bank, **Figure 1** shows the sequential processes which embed risks in every step involved. Bank as a financial intermediary has the main function in connecting left-hand side (funding side) and right-hand side (financing side). The connection implies a build-up risk given that a balance sheet mismatch occurs. Referring to **Figure 1**, number 1 is connected to numbers 2, 3, and 4, which indicates funds deposited are subsequently utilized for financing purposes. Mismatches can be due to dominant proportion between right-hand and left-hand sides. The higher proportion on the left-hand side implies excessive

*Islamic banking as a financial intermediary. Sources: Bank Indonesia [5]. 1. Money deposited; 2. Money*

operational losses compared to operational income, which is proxied by a

financial institutions to follow the economic cycle (*procyclicality*).

bank's capital through a gradual decrease in profitability.

cost-to-income ratio (BOPO) variable.

*Banking and Finance*

*withdrawal; 3. Financing contract; 4. Profit loss sharing.*

**Figure 1.**

**52**

unutilized funds, which will burden the bank's balance sheet as profit diminishes, while the greater proportion on the left-hand side implies excessive utilized funds than deposited funds. Therefore, the imbalance, which potentially occurs as continuous banking operation, will always create risks, in the form of financing risk, liquidity risk, or operational risk.

Although Islamic banking cannot avoid from risk promulgation, there is no adequate evidence on what the source of risk which can lead to balance sheet's vulnerability. The existing literature however mainly focuses on factors that lead to build-up risk in Islamic banking. For example, studies by Abdullah [6], Abedifar et al. [7], Adrian and Hyun (2013), Alessi and Detken [8], and Ardiansyah et al. [9] specifically merely elaborate the determinants of risks and their relationship with a particular risk, such as credit, liquidity, and operational risks. In addition, other studies by Avdjiev et al. [10], Aysan et al. [11], and Borio [12] focus on the relationship of bank's risks with its stakeholders without taking peculiar attention to which risks frequently arise. Therefore, this study will close the gap by empirically examining what is the dominant risk in the Islamic banking given the dynamic and interrelated sides—funding and financing sides—on its operation. For that purpose, three main risks are observed—credit, liquidity, and operational—given that those risks are financially connected to Islamic banking operation. Finally, this paper contributes to the literature on risk management by investigating empirically what is the dominant risks, which are quite lacking, particularly looking at Indonesia's case. Hopefully, findings of the paper share benefits to bankers, depositors, investors, and regulators when taking decisions related to the Islamic banking industry.
